Yet More Stress Test Doubts

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The unduly charitable coverage of the stress tests continues. Even though the New York Times does raise a few questions, it still features industry preening and misses some of the important lapses:

Industry executives reacted with jubilation, as if they had proved their critics wrong and passed the tests with flying colors.

“The results off the stress tests should put to rest the harmful speculation we have seen over the past few months,” declared Edward L. Yingling, president of the American Bankers Association, hours before the results were even made public.

Investors had already bid up share prices of the big banks in reaction to leaks about the results earlier this week.

Regulators and bank executives alike predicted that most of the institutions would be able to build up the necessary capital from private sources — either by selling off assets or by converting shares of preferred stock into ordinary stock.

Now on the one hand, the Times does get credit for distancing itself from the bankers’ crowing about the outcome. However, there is nary a word in the story about:

1. The fact quite a few of the banks negotiated their fundraising requirements down, calling the integrity of the process into question

2. No mention that the purpose of this exercise from the outset was to prove the banking system to be solvent. What kind of a test is that?

3. No mention that asset sales (the reason Citi was able to negotiate its fundraising down from $10 billion, and presumably others as well) are almost certain to be a non-starter.

In fairness, the Times did signal a couple of reservations:

But regulators gave the banks a break by letting them bolster their capital with unusually strong first-quarter profits and also by letting them predict modest profits even if the economy again turns sour.

By contrast, the Financial Times gives a dire report on the prospect for asset sales:

Some banks that require more capital after the stress tests will turn to asset sales to raise money, but their ability to find willing buyers is likely to be limited…

Branches and deposits, which are typically in great demand, will be harder to sell because of accounting implications, bankers say. Such assets usually are sold at a premium. But that would force bank buyers to take charges against earnings for the premium, which is difficult for banks already facing shortages of capital.

Some experts were concerned that a broad attempt at government-supported asset sales could result in another AIG-type situation, in which a sweeping effort to sell assets largely fizzled out.

Many banks have put their asset management divisions up for sale, for example, and attracted little interest. “The government made that mistake already lending money into M&A that didn’t happen,” said one adviser.

“There’s no M&A,” said one adviser. “People have got enough trouble working out their own stuff.”

Asset management operations are normally prized. If these aren’t selling, it’s doubtful anything will get unloaded at a profit (remember, a loss on book value would reduce capital).

The Wall Street Journal , in “How the Stress Tests Stopped the Market Bleeding,” depicts Geithner, the Fed, and Obama as saviors of the market:

Mr. Geithner successfully beat back criticism that the examinations were a political ploy, leaving much of the number-crunching to the Federal Reserve. The stock market regained its footing as consumer confidence crept back. And several major banks reported unexpectedly strong earnings for the first quarter, boosting confidence about their long-term health.

Yves here. Um, the only critic Geithner “beat back” were some of the bankers themselves. The stock market regained its footing because it was oversold and Citi and Bank of America said they’d had a good January and February. The consumer confidence numbers are stronger in no small measure because stock market movements are included in the computation! In fact, in the Conference Board’s release, the stock market rally was the single biggest contributor to the improvement in sentiment. Back to the story:

Investors fretted for weeks that the Treasury wanted to nationalize parts of the banking system, despite repeated efforts by Mr. Geithner and others to dispel that idea….

“Obama stopped bashing Wall Street. They are learning that it’s better to have the market at 8000 than at 6000,” said Paul Miller, a banking analyst at FBR Capital Markets…

A number of analysts pointed out that shares in the 19 stress-tested banks now carry more upside potential than downside risk, if only because the government said in March it would allow none of the 19 firms to fail.

With that assurance in hand, said Brad Hintz, an analyst at Sanford C. Bernstein, the only risk facing bank-stock investors “is dilution risk” — the worry that a firm will need to raise new common equity, which hurts existing shareholders.

Investors “love to have a one-sided bet, and that’s the bet on the financial institutions,” Mr. Hintz said.

Yves again. The illogic is breathtaking. It has now become conventional wisdom that a bankruptcy is the only way to straighten out GM, yet there is no realistic plan for getting the banking industry into a configuration that reduces systemic risk or end incentives for banks to gamble with their now explicit government backstop or a realistic plan to clean up the bad assets (we do not believe the PPIP will succeed). Receivership for the weakest banks is a far better approach for taxpayers and the economy, yet the Journal is touting the line that what is best for incumbent bank management is surely best for America.

And Hintz is kidding himself if he thinks existing shareholders are not exposed to serious dilution, particularly from either nationalization or from debt for equity swaps. It’s way too early to be declaring victory.

Another Journal story did give a useful recitation of some of the stress test shortfalls:

It is hard to quibble with most of the government’s worst-case loss rates, which are calculated for this year and next. For example, an 8.8% loss rate for first-lien mortgages seems suitably tough, even when taking into account the aggressive underwriting during the housing bubble. The government’s 13.8% worst-case loss-rate for second-lien mortgages seems fair. But it is a stretch to think Wells Fargo, with its large home-equity book focused on stressed housing markets, will have a lower-than-sector loss rate of 13.2%.

The government may have been too optimistic in positing an 8.5% commercial-real-estate loss rate. This sector is just starting to fall apart, and defaults may move sharply higher as borrowers struggle to refinance loans…

The government’s earnings projections also need to be taken with a pinch of salt. It is optimistic to assume banks can repeat their first-quarter revenue generation, for instance. Given the Fed has unleashed a tidal wave of liquidity into the system, interest rates are going to be extremely volatile for several quarters, making bank revenue very hard to predict.

Another reason to be skeptical is few banks have to substantially increase overall levels of Tier 1 capital, which includes common and preferred shares, by raising new money. The government is effectively saying most large banks were solidly capitalized even when investors fled earlier this year.

Instead of immediately raising overall capital levels, some banks are just shifting the mix toward common equity — the highest-quality capital. Lenders that need to raise fresh money include GMAC, General Motors’ lending arm. Also, Wells Fargo’s offering of common stock, announced Thursday, suggests its overall capital will increase.

Finally, the government has effectively said it wants banks to have Tier 1 common stock equivalent to 4% of risk-weighted assets. First, investors have to decide whether they have confidence in the risk weightings.

Second, Tier-1 measures of capital leave out certain unrealized losses on securities that could become real later — something captured by tangible-common-equity ratios.

Then they must decide whether 4% — which still translates into 25-to-1 leverage — is safe for the unpredictable environment we are in.

And the other big shortcoming is that the securities and derivatives exposures at the big capital markets players (Citi, BofA, JP Morgan) were given the short shrift.

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  1. Steve Diamond

    What has not been made clear is that if the top 19 banks have to raise $75 billion to fill the gap in their capital that means a very large hole in the economy sits needed to be filled. That 75 billion translates into anywhere from $750 billion in loans (10-1 leverage) $1.2 trillion (20 to 1). Of course, those loans themselves have a multiplier effect once spent. Let’s say that they have a 3 to 1 impact on the communities where they are spent. That means the stress test – as mild as it was – reveals up to a $3.6 trillion hole in the wider economy that the US Treasury wants the banks to fill.

    Not a rosy picture, no mater how much lipstick you put on it.

  2. Richard Kline

    Surprise; applause; one cheer: “Rah.” The Nineteen SCAPgraces of the Rosy Palladium get a gentleman’s C because they’re well, _gentleman_, and Timmy the Music Man leads them in the 137th chorus of “Happy Days Are Here Again.” But will this tattered flop of a soft-shoe shuffle sell tickets to the Casino? And will the checks kite to pay the plastic used to buy those tickets if so?

    And regardless, when the reality that less than half the losses in the whole bust-out have tomatoed the players really comes home in the next few months, what lie will they come up with then? Tune in and find out for the next episode of ‘Krypton’s a Gas If You Don’t Mind a Dying Sun.’

  3. cap vandal

    10 reasons the stress test doesn’t suck.

    Yves has a point of view which I respect, but don’t entirely agree with. The major reason is her emphasis on investment banking. That is only part of the credit system — although I agree that the majority of excesses seem to be associated with them.

    One example that is documented in the report is that out of $8 trillion in assets, there is less than $200 billion in non agency mortgage backed securities — and most of those aren’t of recent vintage or subprime, alt a, etc.

    Wells is raising $6 billion tomorrow morning — 8% of the $75. By the end of the month I expect that about half will be raised – maybe $10 from BAC asset sales. Some of the rest might have to come from converting the TARP preferred.

    This capital raise plus the Goldman and MS raises are the main reason that nationalization isn’t a great idea — capital flows to places where it is treated well. When you start wiping out investors, you won’t see any additional funds from them. Plus the fact that wiping out the common and big chunks of debt includes wiping out taxpayer owned preferred and likely taking down life insurers and pension funds.

  4. Paola

    If the Fed crunched the numbers on the banks that are its private shareholders, then the whole thing is a fraud

  5. Richard Kline

    So cap vandal, there are so many problems with the putative positives you advance here regarding the stress-less tests that I’m going to pass on the rest of that list. But let’s just review:

    No one said that most of the $8T in assets in the banking system are bad. The problem is that the concentration of loss is in the major financials which are holding the rest of the system, the government, and the country hostage to their busted dreams. Your rhetorical attempt to stuff the desperate losses of the Big Few under the skirts of the weary solvent many does you no credit.

    Your reference to mortgage backed securities and their supposed absence from the system as a cause for relief is misconceived. This is well known, yes: most of that paper was on-sold. —And then the Big Lost Few turned around and wrote CDS swaps against those securities for face or against the bonds of those securities purchasers for face, so guess where the ‘loss’ on those securities will progressively boomerang back to? Now the bulk of those losses haven’t been realized yet because the tranching structures of those MBSs were designed to absorb the first losses internally and on the small players. Which is exactly why the Big Few are putting us through this whole dismal charade of ‘solvent today, my friends’ to raise capital _before those swap losses_ are put to them. Think that THOSE exposures were adequately accounted for in these ‘tests,’ my friend? If so, I’m sure that Citi has a slice of preferred they’d love to sell you cheap. Or even dear (I mean why not, the public gets the bill?).

    Then there is the matter of securitized LBO debt you haven’t managed to drag into the discussion, quite a lot of which is left on the sometime ‘speculation’ banks (which is what they should be called). Think that those are marked to market, especially when the minders of accounting standards were dragooned into ‘mark and let mark’ practices?

    In view of these small further matters, without even going into other relevant Concerns, that $6B at Wells, yes that $75 headline ARE COMPLETELY MEANINGLESS NUMBERS. They are numbers for the media and the rubes, but not meaningful estimates of probable losses. If you added a zero on the right end to that Wells raise we might be talking the real money. If it was indeed large private capital standing on the sidelines about to buy in to the six at Wells, I would tell its deployers, Please don’t: start your own clean major bank with it, and make a killing. Although given all the money floating around from the public put to the Big Few which they aren’t investing in the real economy, I suspect that we will have considerable shadow purchases funneld through the hedges to prop up each others equity, here. No smart money is going to buy into Wells, but others in the same boat have every incentive to take public money and quitely support each others’ capital to make the whole show go on.

    The problem we have here, my friend, is that the entire core of the financial system has become an aggregated slime mold of formerly distinct Enrons, bloated 100 times larger.

    And your assurance that large private capital would ne-eev-eerrrr invest in the banking system again if they were nationalized is . . . music to my ears, that sounds about right. We need a banking system which serves the country, not a greed parade that hollows it out. Most of those folks: they’re working with Other Peoples Money anyway, not their own. That money will flow to real return, and real returns will return to the banking system to attract them when said banking system is sound. Which it is not and will not be so long as sham shows like this ‘fooled yah’ examination are promoted by a government which still, as of today, refuses to regulate the financial industry in any meaningful fashion. And that outcome, my friend, sucks dynamite.

  6. Voislav

    What is worrying is that the Treasury still considers 25-1 leverage ratio healthy, which is insane, especially considering the state of the economy. Bank leverage in times like these should be below 15-1, 10-1 would be sensible considering the state of the books. Since banks have a welk’s chance in a supernova of raising that kind of capital, the only way out is to take the banks over. Anything less than that will end up burning more private capital (that can be put to a better use elsewhere) before the inevitable comes.

  7. The Prudent Investor

    How could anybody be in distress after receiving a 2 trillion handout -:)

  8. john bougearel

    Hintz is off his rocker to say the only risk facing bank stock investors is dilution risk. Even if we strip out dilution risk, there is still great market risk in these stocks simply from the short-covering and wildly speculative run-up since March 6.

    Have a clue! If he is advising folks on risk factors, he is a danger to his clients!

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